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BUSINESS DAMAGES MAY BE FOR
THE TERM of a contract, the
technological life of a product or until the
plaintiff could reasonably be expected to mitigate
continuing losses. Opposing financial experts
sometimes arrive at estimates that overstate or
understate the present value of damages.

IF THE PLAINTIFF OFFERS AN
UNDISCOUNTED calculation of future
economic damages at trial and the opposing counsel
fails to object, the error is waived and cannot be
raised on appeal.

DISCOUNT RATES VARY WIDELY,
from a “safe” investment return to much
higher rates. Discount rates in general don’t
behave in linear and intuitive ways compared with
the outcome probabilities.

BECAUSE THE MECHANICS OF
INVERSELY compounding discount rates
may be puzzling to non-CPAs, a CPA damages expert
may choose to testify about a computation by
comparing the numbers of a “best estimate” with a
“hoped-for” outcome in a spreadsheet model.

MINIMIZING THE DIFFERENCE
BETWEEN the plaintiff’s and the
defendant’s discount rates helps a jury reach a
more rational decision. Modeling future damages by
examining variables that can affect future income
helps to accomplish this.

ROBERT L. DUNN, JD, has conducted
commercial litigation for over 30 years and is the
author of Recovery of Damages for Lost Profits.
His e-mail address is attydunn@aol.com
. EVERETT P. HARRY, CPA, is a small-firm owner.
He has served on the AICPA litigation services
subcommittee and is the author of numerous articles.
His e-mail address is eph@ephcpa.com .

PA expert witnesses frequently testify
in court about damages assessments when a plaintiff
alleges future economic losses because of a
defendant’s wrongdoing. Some CPA experts project the
plaintiff’s hoped-for income stream, modify those
losses to a realistic expectation by factoring in
future risks and then discount the adjusted future
losses to a present value at a risk-reduced,
relatively low discount rate. Other experts project
the hoped-for-but-lost amounts and then apply a
higher discount rate that already incorporates risk
or uncertainty to determine the present value. This
article shows why the first approach is easier for
judges and juries to understand.

When, as in the second approach, higher
discount rates are applied to a short, finite
damages period, they may not achieve the expert’s
desired result—that is, the present value of future
damages. However, the first approach—“modeling”
(examining the interactive components of a financial
outcome) and analyzing various input factors
(sensitivity analysis)—does this more accurately.
Working with a spreadsheet program to address
variables (risk) that influence projected earnings
helps us to arrive at appropriate financial-damages
information to offer in court. This article
addresses business damages such as lost profits from
breach of contract or patent infringement.

THE DAMAGES FRAMEWORK

The principle is
deceptively simple: A calculation of a future
income stream must be discounted to a
present-value damages amount and entered into the
record of the legal proceeding. If the plaintiff
offers an undiscounted calculation of future
damages at trial and the opposing party fails to
object, the error is waived and cannot be raised
on appeal—correction is no longer an option.

Cut to the Chase

About
95% of civil lawsuits are settled before trial.

Source: Ogborn, Summerlin and Ogborn,
Denver.

Calculating the present value of future
business damages usually involves two phases. First,
using a spreadsheet program, the CPA expert projects
the lost stream of future income to create a model
that shows lost net profits. The figure is based on
a prediction of lost net sales less their saved
costs such as any variable production and business
expenses. For the overall period of damages (which
usually begins with the occasion of the “wrongdoing”
and ends some finite time thereafter), the
difference between the lost net revenue and the
expenses saved (variable business costs) represents
the plaintiff’s lost profits had the damaging act
not occurred.

Next, CPA experts convert
projected losses of net profits to a present value
using a discount rate (see exhibit 1 ). A
discount rate is the interest rate used to
calculate future receipts or payments at their
present value. (For example, $1 put in the bank
today at 5% interest will be worth $1.63 in 10
years. Therefore, the present value of $1.63 to be
received in 10 years is $1 today at a 5% discount
rate.) The discount rate used should include a
safe rate of return plus factors for risk not
adjusted in the model.

General equity risk
premium Beta coefficient
for the subject industry to
modify the general equity risk
premium Company size
premium

Risk-free

U.S. Treasury
coupon bond, note or bill yield

Experts’ approaches to addressing risks or
uncertainties can be very different, however. Some
CPA experts use discount rates that represent a
return on U.S. government securities or,
alternatively, the cost of funds (interest on
business loans) the plaintiff will face in the
future. The rates are applied to a reasonably
predictable or risk-adjusted stream of lost
profits—perhaps, for a wrongful contract
termination, to those of a contractor who has a
clear, consistent history of profitability on
comparable projects. Others might use higher
discount rates to arrive at present values when
calculating lost profit streams that have not been
risk-adjusted.

Those higher discount rates
contain three components: a risk-free return,
additional return for general equity investment
and company size risk, and premia (other risk
factors) for company-specific uncertainties such
as a small customer base or a time-sensitive
product. Specifically, the higher discount rates
reflect a risk-free or virtually guaranteed
interest rate plus a premium for “systematic”
risk—general equity risk, a volatility modifier
(beta coefficient) and, perhaps, a business size
premium—and “subjective” risk factors that the
expert thinks are applicable. Exhibit 1
shows examples of risk considerations that
underlie the discount rate. The sum of the
risk-free and systematic risk components is the
“base” discount rate, which is the most objective
and verifiable part of the overall discount rate.

The “Total Offset” Rule

With respect to lost wages,
courts have a policy that plaintiffs
with personal-injury claims should be
awarded a dollar amount equivalent to
the stream of income—adjusted for
inflation and invested at a safe rate of
return—that the plaintiff might have
realized but for the injury. In such a
framework, a discount rate doesn’t
reflect factors such as that a company
might have failed or that the individual
might have lost his or her job anyway.
The discount rate for future lost
individual income in personal-injury
cases therefore typically has been about
1% to 3%. Some states, such as Alaska,
apply the “total offset” rule—inflation
plus growth offsets the rate of return
or discount rate—and do not discount
future lost earnings at all, but this
rule doesn’t apply to business damages.

THE CONTEXT FOR DISCOUNTS

At trial, the jury
(or judge or other trier of fact—for simplicity we
use jury throughout) assesses damages.
Because opposing CPA and other financial experts’
estimates sometimes materially overstate or
understate the discounted value of damages, the
jury considers all evidence presented, including
testimony from nonfinance experts and witnesses
who may discuss risk considerations related to
products, services or markets—although seldom in
terms of discount rates.

If the
“wrongdoing” happened well before trial, some CPA
experts project damages from the time it took
place. If certain business risks—for example, the
actual pretrial sales a patent infringer made—have
been settled prior to trial, past (time frame from
wrongdoing to resolution) and future (time frame
from risk resolution to future liability cutoff)
damages can be valued separately. Business damages
can be for the term of a contract, the “life” of a
product or until the plaintiff could reasonably
expect to stop its losses.

HOW TO "MODEL" THE PRESENT
VALUE

Minimizing the difference between the
plaintiff’s and the defendant’s discount rates is
the key to helping the jury reach an accurate and
rational decision. If the CPA expert addresses
risk to the maximum practical extent in the model,
he or she can employ a discount rate ranging from
the risk-free or “safe” rate to one that includes
systematic risk premia. To adjust the information
model

Obtain or prepare a spreadsheet model
of the plaintiff-envisioned “success” outcome,
which reflects the lost sales revenue, saved
expenses and lost net profits. The data should be
arranged by interim time segment (by year, for
example) across the damages period. Automate the
spreadsheet model to use formulas and links that
respond to changes in a key input factors table
(see exhibit 2 ).

Identify the risks the plaintiff
likely will attain lower-than-hoped-for results.
For example, could the future economic returns be
less than projected because unit sales would be
lower, unit prices would be lower or variable
expenses would be higher?

Adjust the spreadsheet model for
these identified risks with the objective of
generating a stream of undiscounted lost profits
that reasonably approximates the most likely or
“expected” (in a probability sense) but-for
outcome.

Calculate the present value for the
risk-adjusted lost profits stream by using an
appropriately risk-abated discount rate.

If the expert believes the damages model
represents the lost income stream with a high
degree of certainty, he or she may elect to use
only a safe rate for discounting. But a discount
rate greater than the risk-free level may be
appropriate if the facts warrant it. For example,
the weighted average cost of capital can be used
if it is consistent with the risk-adjusted model
and will likely make the plaintiff economically
whole over time.

For
business litigation, the courts have held that
future damages must be discounted but historically
have offered little guidance on appropriate
discount rates. Because the mechanics of discount
rates may be puzzling to non-CPAs, an expert may
choose to testify about a damages computation by
comparing the numbers of a “best estimate” to a
“hoped-for” outcome in a spreadsheet model.

Discount rates in general, and subjective risk
premia in particular, don’t behave in linear and
intuitive ways compared with the outcome
probabilities of various events considered in the
damages model. Except for a perpetuity—a very long
time horizon—there is no obvious relationship
between the probability of an outcome and the
subjective risk premia in the total discount rate
(see exhibit 3 ). For finite damage
periods, the subjective risk premia do not change
linearly with changes in the expected outcome (the
risk-adjusted but undiscounted lost profits).

Holding constant all other aspects of the
damages model, including the stream of lost
income, the discount rate—when modeling outcome
probabilities for situations that have less than
100% certainty—declines as the damage period
increases, and it falls exponentially in the first
few years. (An average juror might expect the
opposite result by assuming growing uncertainty as
the time horizon lengthens.)

Next, for the subjective risk component of a
business valuation discount rate, it alone neither
remains constant nor changes proportionately with
variations in the underlying “base” discount rate.
To the contrary, the higher the “base” discount
rate, the higher the collective subjective risk
premia for the overall discount rate is. Damages
experts often treat the “base” and subjective
discount rate components as behaving
independently, which is not the case.

Exhibit 3 presents scenarios using “base”
discount rates of 5%, 10% or 15%, varying damage
periods and varying probabilities of attaining a
stream of constant lost net profits. The exhibit
shows how much each “base” discount would have to
be increased to attain equivalent present values
for the following calculations:

The projected stream of lost income
adjusted to the expected outcome, then discounted
at the “base” rate.

The projected stream of lost income,
unadjusted for uncertainties, and discounted at
the “base” discount rate plus the additional rate
increment to be determined.

The chart in
exhibit 4 illustrates this process for
one subjective risk rate calculation. For any
given “base” discount rate and outcome
probability, the subjective risk component
decreases as the period of damage increases. For
any given “base” discount rate and period of
damages, the subjective risk premia increase
exponentially as the chance of success decreases.
For any given damage period and outcome
probability less than 100% but greater than 0%,
the subjective risk premia increase as the “base”
discount rate increases. Exhibit 3
illustrates that the discount rate component
for subjective risk (thus the overall discount
rate) doesn’t begin to stabilize until well into a
100-year period, far longer than nearly all
litigation damage periods. The subjective risk
component is most volatile at 20 or fewer years
and extremely sensitive at 10 years or less—the
period for which most litigation damage
computations are performed.

It’s difficult to expect anyone to fully
understand the ballooning discount rates required
for shorter damage periods and relatively higher
probabilities that the lost profits will not be
achieved. For example, assuming a 15% “base”
discount rate, a three-year damage period, level
annual lost profits and a 25% outcome probability,
a subjective risk premia factor of 152% is
required—or a total discount rate of 167%—to
achieve the same present value as reducing the
model stream by 75% (that is, 100% less 25%
outcome probability), then discounting at the
“base” rate.

IN PURSUIT OF CLARITY

Although opposing
experts typically present damages scenarios as
impartial and based upon the experts’ experience
or market-derived data, they’re likely to be
related to other companies’ data, may not be
comparable and, usually, are not defined for
plaintiff’s risks. Therefore, damages assessments
that address risk through model adjustments and
sensitivity analyses (evaluation of changing input
factors), and minimize risk considerations in the
discount rate can better serve the court.

Using a risk-adjusted model helps jurors
identify, understand and resolve uncertainty about
what the prospective income stream would have been
but for the wrongdoing (if liability is proved).
An appropriate present value is more easily
determined, and the need for discount rate
modifications in the damages award is minimized if
not eliminated. Judicial decisions in business
litigation are beginning to reflect a trend toward
risk-abated discount rates. The approach described
here is consistent with this trend.

Business Loss
Discount Rate Case Law

Only
four judicial decisions have considered
what the authors believe is the proper
discount rate for future lost profits in
business litigation. None of these has
approved a discount rate above 20%.

American List Corp.
v. U.S. News & World
Report, Inc., 72 N.Y.2d 38, 550
N.Y.S.2d 590 (1989)—An 18% discount rate
was applied at trial but was reversed as
being too high. The plaintiff in a
breach of contract action was not
required to factor in the risk that the
plaintiff might not have been able to
perform the contract which the defendant
had repudiated, thereby excusing
plaintiff’s performance.

Burger King Corp.
v. Barnes, 1 F. Supp.2d
1367 (S.D. Florida, 1998)—A 9% discount
rate was approved in an action by a
franchiser for breach of contract by a
franchisee. The 9% rate was used to
discount the franchiser’s future lost
net royalties over a 210-month period to
present value.

Olson v.
Nieman’s, Inc., 579 N.W.2d
299 (Iowa, 1998)—A discount rate of
19.4% was approved for future
hypothetical patent royalties based on
an expert’s testimony to a 14.4% rate of
return for publicly held corporations
plus 5% for market risk.

Knox v.
Taylor, 992 S.W.2d 40 (Tex.
App. 1999)—The use of a 7% risk-free
discount rate to calculate lost profits
damages for 1994 through 2002 was not
erroneous as a matter of law.